A few years ago the real estate market was running wild and real estate brokers and investors did everything they could to get in on the action. That included using exotic mortgages with variable lending terms, interest only loans, and other unique arrangements, such as the commonly referred to “liar’s mortgage” where lenders didn’t actually verify borrower income. All of these exotic financial arrangements helped create a real estate bubble. Mortgage terms adjusted upward, people couldn’t sell their “investment” properties, and the real estate bubble burst, which led to depressed housing prices and hundreds of thousands of foreclosures.
Now we are seeing a return to the basics when it comes to mortgage lending: the 15 and 30 year mortgages. You can often get other terms if you ask, but right now most lenders prefer to offer a fixed rate 15 year or 30 year before offering other options. The purpose of this article is to show you the pros and cons of a 15 year and 30 year mortgage, hopefully giving you the information you need to choose the best loan for your situation.
Shorter terms equal lower interest, but monthly higher payments
Before we run any numbers let’s look at a basic principle of finance. Assuming you are borrowing the same amount of money at the same interest rate, the following will always be true: Longer terms equal lower monthly payments, and shorter terms equal higher monthly payments. But it also means more interest paid on longer terms and less interest paid on shorter terms.
Based on this principle, a 15 year mortgage means you will pay more per month, but you will pay off your loan off with less interest and in less time vs. a 30 year loan which comes with lower monthly payments, but longer terms and more interest paid over the life of the loan.
How much interest will you pay on your mortgage?
One of the first things we need to look at is how much you will spend on your house. Take the total amount borrowed and the interest rate and plug it into a mortgage calculator, such as this Free Excel Mortgage Calculator from Vertex42.
This will give you the total monthly payment, excluding property tax and homeowners insurance.
Note: Before you sign a loan, your lender is required by the Truth in Lending Act to provide you a statement that shows the total amount of money you will pay over the course of the loan if you make each payment as prescribed by the amortization schedule. (Take a look at how much of your money is going toward interest each month. The final number may be shocking!).
15 year vs. 30 year mortgage – Running the numbers
Looking at the final numbers on the amortization schedule, the 15 year mortgage is a clear winner over a 30 year mortgage. As an example, a $250,000 loan at 5% interest results in total payments of $355,857.13 on a 15 year mortgage and $483,139.46 on a 30 year mortgage – a difference of $127,282.33!
Example 15 year and 30 year mortgage payment comparison:
15 year mortgage ($250,000 borrowed @ 5%):
- Monthly payment: $1976.98
- Total interest paid: $105,857.13
- Total amount paid over life of loan: $355,857.13
30 year mortgage ($250,000 borrowed @ 5%):
- Monthly payment: $1,342.05
- Total interest paid: $233,139.46
- Total amount paid over life of loan: $483,139.46
The 15 year mortgage looks like the best option, however, the difference in the monthly payments is $634.93, which is large enough to make that loan unaffordable for many people. (again, these numbers do not include the property taxes or homeowners insurance, which should be the same, regardless of the duration of the loan).
Compare current mortgage rates for a better idea of what is available in your area.
When a 30 year mortgage beats a 15 year mortgage
In most cases, the interest rates on a 15 year mortgage will be slightly lower than that of a 30 year mortgage, giving yet another reason the 15 year mortgage can be a better option than a 30 year mortgage. But there are times when a 30 year mortgage is better than a 15 year mortgage, and it boils down to one word: flexibility.
A 15 year mortgage locks you into a higher monthly payment than a 30 year mortgage. Even if you can make the larger monthly payments that come with a 15 year mortgage, a longer term may offer your more financial flexibility.
Using the example above, the difference in the payments was $634.93 per month. That difference in cash flow may be enough to cripple you should something happen to your current financial situation – for example, job loss, major home repairs, major medical bills, or other unexpected expenses may arise that could cause short or long term financial difficulties.
The lower payments that come with a 30 year mortgage may increase your cash flow and help you with other financial goals, such as paying down debt, contributing toward retirement, saving for college, or just giving your more month to month financial flexibility.
Remember, you can always pay extra on your mortgage each month, but you can’t always pay less.
Which is better – 15 year or 30 year mortgage term?
If you would have asked me a couple years ago, I would have said that the 15 year mortgage term was better by far. The interest rates are often slightly lower and you end up paying less interest overall because you make fewer payments (sometimes hundreds of thousands less in interest).
But if I were to buy a house today, I would choose a 30 year mortgage and make larger payments if I could afford to pay the difference. That way I get the same effect of a 15 year mortgage and can pay it off in roughly the same amount of time, but I also have the option of scaling back my payments if I need the additional cash flow for other needs. The added flexibility is well worth the longer term and slightly higher interest rates.
What are your thoughts on mortgage terms? Do you prefer 15 or 30 year terms?